Thursday, February 5, 2015

The
impact of the strong dollar on BHP Billiton is complicated and easy to
underestimate: its output is priced in dollars.

Thus,
there are numerous reasons to think the stock is attractive now, including the
price of the stock

As a leading global resource company, BHP Billiton
is widely followed and well-known. BHP
Billiton trades under two symbols BBL and BHP.
Which is the most attractive investment for an individual depends on tax
considerations which are beyond the scope of this posting. Rather, throughout this posting the reference
will be to BBL since it is the appropriate vehicle for most US investors. Because BBL is so well known, this posting
skips doing a detailed description of the company. However, a few things are worth noting
because they relate to the thesis of this posting.

BBL is actually in two businesses. One is the operation of extractive activities
(mines and wells). The second is the
allocation of capital across the development of those resources including the
acquisition and sale of those mines and wells.
The company's history would suggest that it is good at both businesses. One might argue that there is a third
activity: acquiring the right to develop the resources, but as is done above, it
is equally legitimate to just consider acquiring rights as a part of
acquisition and sale of those mines and wells.

Commodity prices can fluctuate over long cycles
where the change in prices can be quite substantial and open to being confused
with a trend. At the same time,
commodity prices can react violently over very short periods of time. Nevertheless, BBL has been able to maintain a
reasonably stable dividend. Yet, the
instability in commodity prices and the consequent fluctuation in the price of
BBL’s stock deters some dividend growth investors. The thesis of this article is that BBL
provides diversification that belongs in a dividend growth portfolio, and now
is a good time to add that diversification.

Many dividend growth stocks are consumers of natural
resources. That is less true of the
pharmaceuticals and consumer staples than the industrials. BBL’s exposure to resource prices is the
opposite of many industrial firms and thus provides a mild hedge. It is only a mild hedge because the same
economic prosperity that affects industrial demand can also affect the demand
for resources. However, the lead times
for developing extractive resources are quite different from those associated
with investments in industrial activities. Therefore, commodity cycles can
develop independent of the business cycle.

For US investors, BBL also provides access to
foreign stock markets, a form of diversification recommended by many financial
advisors. If unhedged for the foreign
exchange risk, it provides diversification across currencies. Also, developing economies are often the major
consumers of natural resources. Thus,
BBL provides exposure to developing markets indirectly. Consequently, BBL’s
stock can be quite volatile, but overlong holding periods it is not highly
correlated with general market volatility.
The beta for BBL is less than one (about .9). Thus, despite the volatility of BBL’s stock
price, it can work to stabilize a portfolio.
The volatility in the stock's price means that the timing of purchases
is very important.

BBL is a global company with operations in many
countries. Its Australian mining
operations are often the focus of analyses, but they are hardly the totality of
the company. That is an important
consideration because, as a multinational, BBL is operating in many different
currencies. It also develops a broad
range of extractive resources, and the prices of most of the commodities BBL
develops are quoted in US dollars.

A recent analysis of BBL on SeekingAlpha focused on
iron ore prices, “BHP Billiton: A High-Yielding Wait For The Iron Ore Turnaround.” This is very good analysis
covering both the company's current strategy and the stock’s valuation with a
good description of why iron ore is becoming increasingly important to BBL. However, when reviewing the analysis, one
should keep in mind that iron ore prices are presented in US dollars. The strong US dollar means that, while iron
ore prices may continue to drop for US consumers, they could simultaneously
rise in weak currencies because of the dollar’s affect. As pointed out above, that is true of many of
the resources BBL develops. They are
priced in international markets in US dollars.

The dollars affect could benefit BBL in a number of
ways. First, when it comes to operating
their businesses, they may produce and sell in areas where the currencies are
weak relative to the dollar. At the same
time, their pricing is based upon the dollar.
Thus, they reap the benefit of operating in weak currency environment
without the pressure of having to sell priced in that weak currency. In terms of the spread between their cost and
their prices, the foreign exchange impact is as if they produced in weak
currency and sold in a strong currency country.
Second, since they operate in multiple countries, they can gear down or
sell operations in strong currency environments and gear up in a weak currency
environment. At a global level that will
reduce their cost.

Because the currency effects are secondary to the
issues addressed in the analysis in the article cited above, they often get
ignored. Many investors will just trust
the management of the company to navigate the issues associated with currency fluctuations. In the case of BBL, the inclination is to
recognize the management has negotiated currency fluctuations in the past and
assume that they are continuing to do so.
Further, there continue to be indications that faith in BBL's management
is justified. For example, the article
cited above mentions that BBL is exiting its low margin coal business in South
Africa, but unlike some of the other divestitures, it is not exiting the coal
business. Rather, it is just adjusting
which assets it retains in which countries.
Similarly, BBL is gearing back its exposure to oil and gas in the US at
the same time it is analyzing the desirability of increasing its exposure in
oil and gas in Mexico.

In summary, for US investors a strong dollar will
make the dollar price of BBL’s lower, but the company’s performance should not
be adversely affected by the strong US dollar.
In fact, the company may actually benefit from the strong US dollar. The company operates in so many countries
that it is probably best to just view it as operating in an environment of
multiple countries with weak foreign currencies. Those countries include both the sources
(i.e., points of production) and markets for BBL. The net effect is that it is a multinational
company that is not adversely affected by the US dollar. It is producing in weak currency countries
and selling at prices quoted in a strong currency. Many dividend growth stocks are going to be
adversely affected by the strong US dollar.
Thus, BBL may offset some of the negative impact.

A previous posting on the Hedged Economist
(Rebalancing and Risk) discussed selling two international stock mutual funds
that had been long-term holdings and shifting to individual stock positions
where the foreign currency risk was easier to understand and more appropriate
given the rest of the portfolio. BBL
fits that description perfectly. That
BBL is a potentially good fit in a dividend growth portfolio has been true for
quite a while. However, because the
stock fluctuates with commodity prices and foreign currency rates, prudence
required waiting a number of years until it became attractive. The combination of the strong dollar and the
overreaction to the commodity cycle has finally made it an attractive
purchase.

Unlike the author of the SeekingAlpha article
entitled “Recent Buy: BHP Billiton PLC,” I did not try to average in. The reasons for thinking it is attractive are
the same as those discussed in the article (PE, yield, restructuring,
etc.). Nevertheless, perhaps out of
frustration after waiting for a number of years for the opportunity, a need to
maintain international exposure, or just out of overconfidence, when the stock
was under $44 it seemed to justify making the entire planned purchase. BBL now has my targeted portfolio weight and
contributes my targeted portion of the dividend flow from my portfolio. At $44 a share, that has been accomplished at
a reasonable price. However, both in
terms of portfolio benefits and the stock’s valuation, purchases at any price
under $50 seems justified.

As one of the dividend aristocrats, Sysco is, or has
been, in the portfolio of many dividend- growth investors. The company’s failures to produce earnings
growth as well as high price earnings ratio have probably taken it off the
radar of many dividend-growth investors.
However, there are reasons to keep the stock on one's watch list.

An article on SeekingAlpha entitled “Sysco: Plunging Gas Prices, US Foods Merger Will Benefit The Company” illustrates the
issue. It points out the benefit that
Sysco could derive from lower energy costs and its merger with US Food. However, it goes on to point out that by many
metrics Sysco's stock is overpriced.
Looking just at those factors, the merger with US Food would have to be a
significant catalyst for improvement before the stock would become appealing. That certainly is a possibility, but without
some evidence that it is occurring, it alone is not a convincing investment
thesis. It justifies watching the
company's performance but not necessarily purchasing a significant position in
the stock.

However, there are other reasons to consider Sysco. The SeekingAlpha article focused on the
benefit plunging oil prices would provide as a result of Sysco’s energy
consumption.That reduced cost to the
company could improve profits and margins.There is another impact that the market may be overlooking.That is the influence of energy on the demand
for Sysco's services.

Food away from home, the source of demand for
Sysco’s services, is influenced by energy prices in two ways. Reduced gas prices lower the cost to the
consumer of going out. The cutback in
driving associated with high energy prices usually focuses on long trips, but
it probably also influences local discretionary driving such as going out to
eat. Lower gasoline prices would reverse
that impact. Second, the US consumer is
a major beneficiary of reduced energy costs.
As a discretionary purchase, food away from home will be a beneficiary
of the increase in discretionary income of consumers. A previous posting entitled “Markets in Motion” expressed some skepticism about analysts’ estimates of the impact of oil
prices on earnings. Specifically it
stated: “While the energy sector’s earnings will be reduced, earnings in some
other sectors will benefit.” Sysco is an
example of the company that could be a beneficiary.

The current raft of earnings
reports where negative currency translations have resulted in earnings that
disappointed investors has probably provided an investor with an intuitive
understanding of what generalized foreign currency exposure means. For anyone who still does not understand why
foreign currency exposure is important, a quick reading of two recent WALL
STREET JOURNAL articles should help.
“Swiss Franc’s Leap Lifts Some FX Brokers”on Monday, January 26 and
“Currency-Trading Volumes Jump” on January 28 both make mention of the amount
of money involved in currency trades.
When more than $4 trillion (note that's trillion with the t) is flowing
in a single day, it will easily overwhelm any actions taken by the management
of any corporation. Sysco's US focus
means it is not as exposed to currency risk as many other corporations.

At the same time, there is a
potential benefit to Sysco from the strong dollar. A strong dollar will reduce the price of
imports. Consumers of imports, US
citizens for short, will be beneficiaries of those lower import prices. That will increase their discretionary income
which could benefit Sysco if it results in increased demand for food away from
home.

Reduced cost as a result of
lower energy prices, reduced risk as a result of its US focus, and the economic
tailwinds that could result in an increase in demand for Sysco's services, are
all factors that will take time to have any impact on Sysco's
profitability. So, it would be a bit
naïve to expect them to have their major impact on the upcoming earnings
report. They might, but waiting for the
earnings report and carefully examining it for any indication that these factors
are starting to show is a viable strategy.
There is a difference between operating in an economically beneficial
environment and actually benefiting from it.
The latter requires that management capitalize on the beneficial
economic environment.

Despite the cautions above, I have initiated a
position in Sysco due to portfolio considerations. A previous posting entitled
“Rebalancing and Risk” discussed why an investor might want to reduce his or
her exposure to generalized tail risk. It focused on mutual fund holdings and on tail risk. However, even
without tail risk, many investors, especially those seeking dividend growth,
may have significant exposure to a large number of multinationals. As a consequence, they may have taken on a
substantial amount of generalized foreign exchange exposure. That would not be the case if one is loaded
up on REITs, pipelines, US banks and utilities.

However, a previous posting, “The Widows’ andOrphans’ Portfolio and US Banks,” presented a core portfolio for a buy-and-hold
investor. With the exception of Verizon,
all of the holdings are multinational.
As a core portfolio, many of the stocks have been held for a long time
(decades) and represent significant portions of the total portfolio. Also, the posting suggested that an investor,
at least this investor, might want to avoid regulatory risk. It is difficult to find utilities and banks
where the regulatory risk is acceptable.
Even pipelines and some REITs have regulatory risk.As
consequence, many of the non-core holdings are similar to those discussed in
the posting.

Investors can find themselves in a position of
searching for domestic exposure that is relatively “regulatory risk
free." Sysco is such an
investment. There is no magic formula
that can tell the investor how much of their portfolio to shield from foreign
exchange fluctuations or, for that matter, regulatory risk. With only 10% of my portfolio distributed
across seven stocks that are primarily domestic in their orientation (NNN, GAS,
HCN, WTR, WFC, TRP, VZ) Sysco is appealing from a portfolio perspective.

Given that conclusion, two issues remain: what role
will it play in the portfolio, and when and how should it be acquired. Regarding the first issue, a SeekingAlpha
article entitled “Modern Graham Quarterly Valuation Of Sysco Corporation”
provides pretty good guidance on what role it should play. It will not be a core holding, but it is not
totally a speculation.

Timing the acquisition of any stock is always an
issue.A good stock at a bad price is
not a formula for success.Thus,
acquiring some of the intended position ahead of earnings may work for some
investors, but given the economic tailwinds that could benefit Sysco, putting
it on a watch list and examining its earnings release closely is a justified
use of time for many investors.The
company has become very interesting again.

As
a bank with significant operations in both Canada and the US, the weak Canadian
dollar could benefit TD bank.

The
Canadian central bank’s rate cuts enhance TD’s appeal

A recent (Jan. 16, 2015) article on SeekingAlpha entitled “Toronto-Dominion Bank Analysis Points Toward Growth," provided a general summary
of the advantages of TD bank as a growth story for investors considering a
Canadian bank.Rather than repeat that
discussion, this posting focuses on characteristics of TD bank that should
resonate with US investors.

However, before focusing on characteristics that
should be important to US investors, the article makes a point that should be
relevant to all investors: “TD's latest report shows profit continuing to be
made, but falling shy of analysts' expectations, which those analysts deem a
signal of stagnation. Reuters's data predicted $1.05 in earnings per adjusted
share and $1.00 per share of net income, but were disappointed when faced with
98-cent profits per share and a 91-cent per share of net income. With these
results came a 2.71% decrease in stock price that same day.”

For short-term investors, missing an estimate is
justification for selling, but often for a long-term investor it is an
opportunity to purchase a stock that is temporarily depressed because of the
short-term focus of many other investors.I view it in the latter sense and increased my holdings of TD at 10%.Less that be interpreted as an effort to try
to time the market, the balance of this posting focuses on the other reasons
for purchasing TD bank shares.Thus, the
earnings miss just influenced the timing of an investment that was planned for
a variety of reasons, including the company's long-run prospects as indicated
by its fundamentals and portfolio considerations.

For a US investor, the most compelling reason for
considering Canadian banks remains the issue discussed in a March 5, 2014
posting entitled “The Widows’ and Orphans’ Portfolio and US Banks.”If possible, one would want some
representative of the financial sector included in a portfolio for
diversification.Canadian banks are
subject to far less regulatory risk than US banks.Reading about and receiving notices
concerning lawsuits against you as a stockholder gets tiresome, and one should
avoid it if possible.

When addressing any investment in Canada, the US
investor has to keep exchange rates and energy prices in mind.A good illustration occurs in an article
published on January 16, 2015 in the WALL STREET JOURNAL.It was entitled “What’s the Matter With Canada?” The major thrust of the article concerns Canada's manufacturing sector,
but it was impossible for the article to thoroughly address that issue without
discussing the impact of oil prices on the Canadian dollar.The same is true when looking at Canadian
banks.It is how energy prices and
exchange rates relate to TD bank's business profile that makes it an appealing
investment for US investor who is choosing among Canadian banks.

The first thing to note is that foreign exchange
rates do not influence the desirability of TD bank's shares in the same way
they would many other Canadian companies.The shares on NYSE are not ADRs. They are a special class of interlisted
securities.That is true of many
Canadian banks. You are buying US shares directly, not ADRs.So, the US investor is not exposed to foreign
exchange risk in the actual price of the stock.

For TD bank, the advantage of listing on several
exchanges is that it allows the company's shares to gain access to more
investors and increases a company's liquidity.The shareholder is exposed to the sentiment of investors in multiple
countries.Thus, the TD bank shareholder
has exposure to a foreign stock market without the direct foreign exchange
risk.It is diversification across
markets without direct foreign exchange risk in the price of the stock.

Similarly, the US investor holding any Canadian bank
has diversified their portfolio to include exposure to a non-US economy.That is true of any international company
whether headquartered in the US or a foreign country.In the case of TD bank, that exposure is
easily quantified:25% of the bank's retail bank earnings
come from the US, 65% come from retail banking in Canada and 10% come from
wholesale bank.

Looking at the correlation between the US and
Canadian stock market and economies, one sees that the diversification benefit
exists, but it is weak.From the portfolio
perspective, that weak diversification across stock markets and economies when
combined with the diversification benefit of being able to hold a bank stock
without the regulatory risk provides the basis for putting TD bank on one's watch
list.

What is important is how foreign exchange rates will
affect the profits of TD bank.TD bank
is the fastest-growing Canadian bank. It has a presence outside of Canada that
is as large, but not as profitable as its Canadian base. It was the American
side of business that specifically concerned analysts.While only 25% of the bank's retail earnings
come from the US, it represents a much larger portion of the bank's retail
operation (about 50%) when measured by number of branches.

That TD bank earns a lower return from its US
branches is not surprising.TD bank is
essentially exporting services into one of the most competitive banking markets
in the world.It is easy for Canadians
to overlook the fact that in the US all one needs is to have 10 bucks and a politician
in your pocket, and you can open a US bank.That TD has been able to compete in that market and maintain overall returns
that are competitive with other Canadian banks is very much to its credit.

Like many exporters that have their production
facilities in the country where they sell the product, TD bank benefits from
the international operation through its impact on its earnings when translated
back to its native currency.In Canadian
dollars that 25% of earnings that originate from US operations will increase
without any increase in the efficiency or scope of the US operation.It is, if you will, the opposite of the
foreign currency translation that will negatively impact many US
multinationals.From the US investor’s
perspective, it is an opportunity to invest in a situation where the strength
of the US dollar benefits the holding.

Just as foreign exchange developments justify
putting TD bank on one's watch list, energy market developments also justify
giving TD bank a close look.TD bank's
footprint is far less affected by energy prices than most Canadian banks.In the US, TD branches are located in areas
that benefit from lower energy prices.Thus, the retail customers they serve are benefiting and should be
better bank customers.Also, the bank is
not overly exposed to commercial loans to the energy sector.

TD bank has relatively limited exposure to the
current slumping oil market.It would be
a mistake to view that as just avoidance of a negative situation.In fact, it creates a very positive
environment for TD bank.The central
bank of Canada just cut interest rates which should guarantee that the
favorable foreign currency affect discussed above will grow.

At the same time, one of the concerns regarding
Canadian banks is the potential that Canada is developing a housing bubble and
a consumer debt bubble.The lower
interest rates that are the central bank’s response to the impact of energy
prices on the Canadian economy should, at least temporarily, mitigate any
impact of the perceived bubbles.However,
the US investor is aware that the bubble in the US housing market was a product
of our institutional framework.No
similar chaotic institutional pursuit of serving consumers who want to increase
their leverage seems to exist in Canada.

Lower interest rates are generally viewed as
unfavorable to banks.They pressure the
interest rate margins.However, as
discussed in a SeekingAlpha article entitled “Surprise rate cut not yet feeding through in Canada,” TD has not immediately respond by lowering its interest
rates.Until they do, the impact on
interest rate margins will not show up.

It is important to keep in mind that for 50% of TD
bank's retail operations, US interest rates are equally important.If the US central bank raises interest rates
as is expected, interest rate margins on the US portion of TD bank's operations could
improve.That improvement would occur at
the same time that a strengthening dollar is making the earnings of US
operations appear more significant in Canadian dollars.The divergence between the policies of the
central banks of Canada and the US should ensure that the benefit to TD bank
persists for a while.

In summary, TD's appeal applies to both Canadian and
US investors to the extent that it results from the interaction of its geographic
footprint and the effect of a weakening Canadian dollar.What is unique from a US investor’s
perspective is the ability to diversify across stock markets and national
economies without incurring foreign exchange risk directly.When that diversification risk is added to
the ability to avoid the regulatory risk embodied in US bank stocks, it makes
TD bank an appealing alternative.That
the impact of a strengthening dollar on TD bank's earnings could be the
opposite of the impact of the strengthening dollar on other holdings of
multinationals just adds to its appeal.

Friday, January 23, 2015

What
is tail risk and how does it relate to the stability of the correlation matrix?

How
does it interact with rebalancing?

Is
it possible to identify the benefit one gets from rebalancing based upon market
developments?

How
do oil price fluctuations and foreign exchange fluctuations relate to the
benefit of rebalancing?

What
are the implications for a US investor’s international holdings?

This posting advances the notion that instability in
the correlation matrix is indicative of a rise in the potential tail risk. Further, the potential for tail risk should
inform an investor’s approach to rebalancing his or her portfolio. The conclusions drawn in this posting may be
unique to market fluctuations caused by oil price and exchange rate
instability. The posting does not
attempt to look beyond potential consequences of oil price and exchange rate
instability. It concludes by looking at
the investment implications of the central thesis regarding the relationship
between the correlation matrix and potential tail risk. Not surprisingly, the conclusions regarding
the implications vary dependent upon one's home currency. This posting focuses specifically on the
implications for US investors.

In finance, “risk” is usually equated with
volatility. Sticking with that
definition, tail risk would be extreme volatility. It is important in financial markets because
of the phenomenon known as the fat tail: basically, the probability of an
extreme event is higher than what one would assume from a normal
distribution. According to that
definition, tail risk is just the same as “risk.” It is the probability that makes it significant.

A second definition of tail risk is a low
probability event that has huge consequences.
The second definition does not quantify low probability. Instead it focuses on the magnitude of the
consequences. However, it is silent on
whether those consequences are the volatility of the variable concerned or some
other event that is triggered as a result of the low probability event. Volatility of the variable is illustrated by
a tendency for the amount of change to go exponential when it approaches an
extreme. Triggering of some other event is
illustrated by, for example, an extreme change in the price of a commodity
forcing a government to default on its loans.

The final candidate as a definition of tail risk considers
a phenomenon in finance that is extremely important. It combines elements of the two previous
definitions. It is associated with, and
perhaps a consequence of, extreme volatility.
When there is extreme volatility, it is often accompanied by a breakdown
in the relationship between different financial assets. In financial jargon, the correlation matrix
breaks down.

Being statistical measures, how well things are
correlated are not a constant. They
fluctuate. Thus, while a breakdown in
the correlation matrix is often associated with tail risk as defined in the
first and second definition, it also sometimes occurs without the realization
of tail risk. A breakdown in the
correlation matrix can be viewed as a necessary-but-not-sufficient condition
for tail risk.

This last definition based upon the stability of the
correlation matrix has the advantage that it provides room for recognition of
the fat tail of the distribution of returns and it defines “the event with huge
consequences” in terms of financial market performance. More importantly, tail risk usually proceeds
quickly. By contrast, deterioration of
the correlation matrix can be seen before it completely breaks down. Thus, one can view the deterioration in the
correlation matrix as a continuous variable that will change going into a tail
risk event as defined in the first two definitions.

The previous posting, “Markets in Motion,” talked
about the market volatility in oil prices and foreign exchange rates. Both phenomena raise the probability of tail
risk by all three definitions discussed above.
Historically, extreme foreign exchange rate fluctuations have been
associated with equally extreme economic and financial events. The reason for the extreme importance of
foreign exchange rates is simple.
Foreign exchange rates feed through both to the stability of the
financial system and the performance of the underlying economies.

Many financial advisors recommend rebalancing a
portfolio regularly. The end of the year
or the beginning of the new year is a convenient time for financial advisors to
include a reminder about rebalancing.There is no magic associated with annual rebalancing, but the change in
the calendar does provide a convenient marker for financial advisors or
investors who need a reminder.

Rebalancing a portfolio is often presented as a way
for an investor to reduce risk that may have developed as a result of
differences in performance of different assets.
However, in fact,rebalancing does not necessarily reduce or increase the
risk in a portfolio. Whether it
increases or decreases the risk depends upon what assets are being sold and
what are being bought. (Technically it
depends upon the volatility of the assets being bought and being sold). The real reason for rebalancing is to keep
the risk-return profile stable at some level initially set to represent the
investor’s risk tolerance.

A previous posting entitled “Does AlgorithmicTrading Make Sense for Small Investors?” discussed the limitations on some of
the assumptions associated with the approach when applied across asset
classes. Instability in the correlation
matrix was one of the limitations mentioned.
So far, the phenomena discussed in “Markets in Motion” have not resulted
in tail risk in this sense, at least not for US investors. Consequently, for a US investor, rebalancing seems
to have achieved the desired results so far in 2015. For example, as stock prices declined, bond
prices increased. (It is worth noting, however, that when one takes a global
perspective, rebalancing has not worked for investors in every country).

However, when examined closely, it can be seen that
rebalancing appears to have achieved the desired objective, but that appearance
is due to returns.The point of
"Markets in Motion" was that the phenomena being discussed, oil
prices and exchange rates, have increased volatility of all assets.The portfolio’s overall risk has changed if
the change in the volatility of different asset classes is not uniform.It seems naive to assume that the volatility
of all asset classes is changed in the same way.

In order to achieve a rebalancing that maintains the
risk-return profile, one has to forecast not just how returns vary with
fluctuations in oil prices and exchange rates, but also how volatilities of
each individual asset class is changed.
In and of itself, the fluctuations in volatility may make any portfolio
of financial assets more risky. That is
true if the fluctuations in oil prices and exchange rates increase the
volatility of all asset classes. It is
also conceivable that it would reduce the risk.

To illustrate using just using US stocks and bonds,
in 2014 the returns on stocks and bonds can be represented as follows: the
S&P (NYSEARCA:SPY) delivered 13.5%, a broad-based bond index (NYSEARCA:AGG)
delivered 6%, long-term Treasuries (NYSEARCA:TLT) delivered 27.3%. Thus, a portfolio of stocks, bonds and
Treasuries would be rebalanced at the end of 2014 by selling Treasuries and
increasing stocks and non-Treasury bond holdings.

One way to view that rebalancing is to believe that
during 2014 the increase in the value of Treasuries reduced the risk in the
portfolio to the point where rebalancing into stocks and bonds was needed in
order to restore it to a given risk-return profile. In other words, the rebalancing is needed to
restore the risk that was eliminated in the portfolio by the increase in the
weight of the Treasury component. The
alternative is to view the volatility associated with a higher returns to
Treasuries as implying that they are more risky than they were going into 2014. In this view, Treasuries are now viewed as an
asset with greater risk than they had at the beginning of 2014. Selling the Treasury reduces the risk because
Treasuries have become more risky assets.

One could argue that because an investor must anticipating the impact of oil and exchange rates on two variables (the level
of asset prices and their volatility) it has introduced additional
uncertainty. That is a real source of
increase in risk, but it is not potential of tail risk. The important change in the risk associated
with any portfolio becomes apparent when one adopts a definition of tail risk
that involves only financial assets. For
the US, it is reasonable to assume that the increase in the price of Treasuries
has increased their potential volatility.
It is easy to dismiss that as just true of any asset that gains
significantly in price.

However, one should keep in mind that a significant
portion of the increase in the price of Treasuries is a response to foreign
exchange fluctuations. In short, foreign
exchange rates have made Treasuries more risky by increasing their price. But again, that is just normal portfolio
adjustment. Once one starts to think in
terms of global investors, one has to realize that each investor has an
investment option that is analogous to Treasuries for US investor. That option is their home country’s sovereign
debt. Some of the investments moving
into Treasuries last year, and especially so far this year, moved from foreign
countries’ sovereign debt. However, those
flows come from both equity and bond holdings in those foreign countries. The correlation between stocks and bonds has
broken down for those foreigners if funds flow out of all asset classes.

For the US investor, the potential for tail risk is
currently concentrated in the international portion of their portfolio. A previous posting entitled “Funds for AssetClass Diversification” discussed two mutual funds used to achieve international
diversification. The posting also
discussed the philosophy behind holding those two funds. They are treated similarly to any other
position. Thus, mutual funds are not the
only way international diversification is achieved. In addition to the funds there are individual
stocks in non-US companies. The
potential of tail risk impacts each fund and individual stock holding
differently. Since this posting has so
far discussed rebalancing in terms of asset classes, the balance of this
posting will focus on the funds. Individual
stocks will be the subject of future posting.

The two funds in question are Spartan International
Index Investor Class and the Lazard Emerging Market Equity Blend Portfolio. The reader should keep in mind that it is not
these particular funds that are at issue.
They were just chosen as representative of an asset class. That is the role they played in the
portfolio, and it is their role in this posting. So, the issue becomes whether just having a
representative of the asset class continues to make sense.

If the hypothesis that volatile foreign exchange rates
and oil prices have increased the tail risk associated with foreign assets is correct,
neither fund continues to provide the benefits that justifies including it in
the portfolio. In addition to the diversification benefits, the funds also embody a new higher probability of tail risk. An alternative strategy
is to focus on specific stocks in non-US companies as a way to avoid the tail
risk. It should be possible to pick
countries and companies that are less exposed to the potential of a collapse of
the financial system of the country.

Since both funds include equities denominated in a
variety of currencies, shifting to individual holdings could increase the
currency risk as well as the company specific risk. However, the tail risk seems to justify
accepting the need to bear the foreign currency risk. The currency risk was always there; picking individual
holdings just makes it apparent. The
decision regarding how many non-US stocks and how many currencies have to be represented
then becomes an issue of how confident the investor is in their ability to
trade off tail risk against more concentrated currency and stock specific risk.

Sunday, January 18, 2015

Lower oil prices are beneficial for oil consumers
whether they be oil-consuming countries or consumers in the US filling up at
the gas pump.That does not mean they
are beneficial to financial markets.The
price of a financial asset is determined by the return one expects to earn from
holding the asset and the amount of risk or uncertainty associated with that
return.A rapid change in any
environmental factor increases the uncertainty associated with the return and
therefore reduces the value of the financial asset.

There have been numerous articles about the falling
fortunes of the oil sector.On January
19, 2015 BARONS presented a summary of one analyst’s estimates of how much the
earnings of the S&P 500 would be reduced by the reduced earnings of the energy
sector.The estimates do not seem worth
quoting since they were developed without addressing the issue raised by the
first sentence of this posting.While
the energy sector’s earnings will be reduced, earnings in some other sectors
will benefit.The net result is the
introduction of considerable uncertainty into any forecasts of the profitability
of a large number of companies.That
uncertainty will repress stock prices.

Thus, the uncertainty introduced by rapidly changing
energy prices definitely has stock market implications.However, the December 17, 2014 posting
entitled "Oil Prices" pointed out that the greatest macroeconomic risk
associated with falling oil prices would be their impact on foreign exchange
markets: “The foreign exchange markets are so big that a major dislocation
there can have all sorts of unanticipated consequences.”The financial market implications of foreign
exchange

Furthermore, it is quite conceivable that foreign
exchange markets and oil markets could reinforce each other.They could reinforce each other in terms of
their financial market impact even when their macroeconomic impact diverges.By introducing instability, they both could
be contributing to lower stock prices by increasing the risk associated with
holding stocks.That can be true
regardless of whether they have a positive or negative impact on the return.

The December 17, 2014 posting went on to note: “One
should keep in mind that financial institutions make markets in both currencies
and foreign bonds.If a major financial
institution gets caught with excess inventory of the wrong currencies or bonds,
dislocation to the financial system could be significant.” One could argue that
financial institutions also make markets in commodities such as oil, and therefore,
that risk should be noted.However, as
big as it seems, commodities markets are small compared to foreign exchange
markets.

The scope includes non-oil commodity prices (e.g.,
gold), earnings of banks, pressures on central banks in countries like Denmark,
impacts on the economies of many nations, government bond yields, stock market prices
in some nations, and the reputation of central bankers.The disruption is not just restricted to
turbulence in all those markets, it also involves financial institutions closing
their doors (e.g., Global Brokers NZ Ltd.) or having to raise additional
capital (e.g.,FXCM Inc.).

On January 17, 2015 the WALL STREET JOURNAL reported
estimates of the losses of a number of financial institutions.The article entitled “Surge of Swiss Franc Triggers Hundreds of Millions in Losses” included estimates for Deutsche Bank
and Citi.While the hundreds of millions
of dollars involved might seem significant, for US banks they pale compared to
the regulatory risk pointed out in the March 5, 2014 posting entitled “The Widows’ and Orphans’ Portfolio and US Banks.”Nevertheless, they are just one more reason to avoid US banks in a
portfolio designed to have a low volatility and a stable return.

Even when addressing issues that seem totally
unrelated to foreign currency, it is impossible to ignore a market as large as
the foreign currency market.A good
illustration occurs in an article published on January 16, 2015 in the WALL
STREET JOURNAL.It was entitled “What’s the Matter With Canada?” The major thrust of the article concerns Canada's
manufacturing sector, but it was impossible for the article to thoroughly
address that issue without discussing the impact of oil prices on the Canadian
dollar.

It may well be that the decline in US stock prices
so far in 2015 is an adjustment to the uncertainty introduced by the volatility
in oil prices and currency markets.It
certainly is consistent with the increase in uncertainty or risk associated
with holding stocks.However, when
foreign currency fluctuations are involved, there is a significant increase in
what is known as “tail risk.”Countries
can default, financial institutions can go broke, and governments can be forced
to support their financial system and their economies.Such shocks are often viewed as exogenous and
therefore impossible to predict.

It is true; they are impossible to predict and this
posting in no way constitutes a prediction that they will occur in the US.However, they are not totally exogenous and
the ground is fertile for them to occur.Just that fact will impact the return on financial assets.The first half of 2015 will provide
significant opportunities to investors as companies adjust to the recent
volatility in oil prices and currency values.The next few postings will address their portfolio implications, but
what is apparent is that regardless of what adjustments are made in a
portfolio, the risk associated with any asset has increased.

Monday, January 12, 2015

The WALL STREET JOURNAL had an interesting opinion
piece by Gerald Walpin on Jan. 6, 2015.The title “How to Stop a Class-Action Scam” undoubtedly caught the
attention of most investors.The column
noted that, “If you own any stock, you know the frustration of getting a notice
announcing settlement of a lawsuit, commenced by a lawyer on behalf of a class
composed of all shareholders—you included.”

The article points out that generally the members of
the class received little or nothing as a result of the suit.At the same time, the members of the class
have to pay the lawyers filing the suit millions of dollars in fees.The class gets to pay for suing itself.In essence, the class-action racket is set up
to add injury to insult.

The author talks about the class-action abuse in
general terms and then goes on to use a specific example: “Case in point: On
Nov. 10, 2014, I received a class-settlement notice regarding my Verizon
stock.”Verizon was one of the stocks
identified as a part of the “Widows and Orphans Portfolio” in a posting at the
beginning of 2011.It is a part of a
core portfolio that has been discussed a number of times since then.

It is no accident that the suit was filed against
the type of company that would be in a portfolio for widows and orphans.Large-cap, widely-held stocks are the perfect
target for these class-action criminals.The management, constrained by their fiduciary obligation to their
stockholders, will settle in order to avoid a costly defense.In addition, the wide dispersion of stocks
ensures that it is unlikely any single shareholder will find the expense of
objecting to the outrageous legal fees of the class-action lawyers worth the
cost of intervening.In short, widows
and orphans make good targets for this extortion racket.

As someone who has managed a portfolio of common
stocks for many years, The Hedged Economist has probably been defined as a
class member a couple of dozen times. The experience has provided an
opportunity to read through many class-action notifications.It is amazing how totally corrupt and
absolutely imbecilic the process is.In
fact, it is so bad that it is difficult to figure out where to start in terms
of any thoughts of how it could be reformed.

What is worse is that the process has been set up so
that an individual is unable to protect oneself.The simple solution would be if government,
in its infinite wisdom, would recognize that perhaps individuals are able to
judge whether they are victims of the abuse the class-action lawsuit supposedly
addresses.However, instead the
government has set things up in such a manner to make it inconvenient to avoid
being defined as a member of the class that has been selected to pay the
class-action lawyers their ransom.

In fact, in some instances opting out of the lawsuit
requires providing confidential information that an investor may reasonably
choose not to disclose.Clearly,
disclosing information such as Social Security number, brokerage account
number, name and address (despite the fact that they have already mailed items
to you) is not something that should be undertaken lightly.Especially, when the disclosure is to
individuals who have demonstrated that they are probably crooks willing to
undertake frivolous lawsuits for personal gain.At a minimum, they have demonstrated that they are not acting in your
interest, and disclosing information to such individuals is more likely to
result in harm than benefit.

Since our elected officials have known about this
corruption of our legal system for years, one would be foolish to assume that
they will address it.One can hope,
however, that the consumer watchdog organization for financial products created
as a result of the Dodd-Frank legislation would recognize that stocks are a
financial product and stockholders should be protected from this sort of
extortion.

Friday, January 9, 2015

Friday's jobs report showed a drop in the
unemployment rate, a growth in payroll employment, and a decline in the average
wage.Many observers cannot understand
why the wage would go down when the unemployment rate and pay-rolled employment
indicate a tightening labor market.The
reason is obvious.However, before one
can see it, one has to discard the notion that there is an aggregate labor
market.

Unfortunately, many observers, especially economists,
are blinded by the Marxist notion that there is a great lump of something
called labor.If you assume all labor is
homogeneous and all jobs are homogeneous, then a tightening labor market should
increase wages, but no such homogeneity exists.The theory was wrong when Marx advanced it and it is still wrong.People are individuals.Each job requires a different set of skills
and contributes a different amount to the output of the organization hiring the
individual.

It never occurs to observers that as markets tighten,
they increasingly draws in individuals who are less productive, less willing to
work, and less skilled.Not
surprisingly, those individuals cannot command the same wages as the individuals
who are already employed.

What is surprising about this inability to see the
obvious is that there has been considerable handwringing about the loss of
skills attended with long-term unemployment.Also, anyone paying attention has noticed that the unemployment rate
among the prime working age population has been consistently lower than the
unemployment rate of demographic groups more marginally attached to the labor
market.The young and those with less
education, as well as those most inclined to just drop out of the labor market,
represent a disproportionate share of the available labor.

Also, as the economy expands it becomes profitable
to employ people to work on things that would not be worth it if the economy
were not expanding. There is also what is referred to as the composition
issue.Put simply, the composition issue
is the question of what firms are hiring and whether those firms are in high
wage industries hiring for high wage occupations.

For those who love to see a political issue in any
economic data, there is also the impact of the incentives our government
provides to employers to avoid hiring people for full-time jobs.Part-timers tend to earn less than full-time
employees.Finally, lest we forget,
wages are quite different from employee compensation, and we have enacted
legislation that mandates the substitution of health insurance for higher wages
in many instances.

So, let the handwringing continue; it is easier than
giving up an obsolete theory.

About Me

No surprise: The Hedged Economist is an economist. I’ve been at it for more years than I like to admit. If one leaves graduate school with a degree in economics, there are really only three options short of abandoning the degree and starting over. The options are: “doing” economics, telling people about economics, and applying it to your own affairs. I’ve done all three. I’d even say I’ve done OK in all three.
Nothing on this website should be taken as investment advice. Always do your own due diligence.